Closed-end fund discounts keep bouncing around

MurrayColeman

SAN FRANCISCO (MarketWatch) -- As credit tightens and lending slows in debt markets, closed-end funds are trading at much bigger discounts than just a few years ago.

But that doesn't make them screaming bargains, say some observers.

While several well-run portfolios with veteran managers could still appeal to long-term investors, analysts say red flags abound as market conditions remain volatile and prices swing widely from week to week and even month to month.

"Closed-end funds have staged an impressive rebound rally," said Frank Sileo, a Citigroup analyst, in a new report. "However, many of the risk factors that led to substantial price weakness earlier this summer remain unresolved."

As a result, closed-end vehicles have two prices. One is similar to an open-end fund's net asset value, which reflects pricing as a whole of underlying issues. But since existing closed-end shares can be traded on exchanges throughout the day, a market price is also set for each portfolio.

The difference between the two either runs as a discount or premium to a fund's NAV. During the recent credit fallout, market prices declined more than NAVs. As a result, bond fund discounts widened to an average of around 13.5% by mid-August, according to Citigroup's research.

It finds that those discounts have narrowed considerably since then, though. "Some funds are even back to trading at premiums," Sileo said.

Volatility picked up noticeably in July and August in closed-end markets, said Tom Roseen, a Lipper Inc. analyst.

"Closed-end funds are getting to be a little pricier," he said.

Some 63% of the 696 closed-end funds Lipper tracks are bond-oriented. At face value, many still offer some attractive values.

"If short-term interest rates go up, this may not be the time to jump into a closed-end bond fund," Roseen said. "On the other hand, if the Fed cuts rates, then this might be a very attractive opportunity to move into a closed-end bond fund."

Recent pricing patterns in closed-end bond funds are showing up in stock-focused closed-end funds. Lipper listed through July the average discount on an equity closed-end fund at around 4.17%. That was some 1.4% wider than its 12-month average rate.

The typical bond closed-end fund had a discount of around 5.74%, some 2.2% more than the year's average.

"Both equity and fixed-income closed-end funds are trading at attractive discounts compared to what we're used to seeing over the past few years," Roseen said. "But they're still not as wide as we've seen over longer periods."

He's cautioning that investors should take a very careful review of what closed-end funds they're considering at this point. "You've got to look at the underlying fundamentals of each fund and what it holds and what strategy it uses in this type of market," Roseen said. "Just because a fund has a 10% discount doesn't make it a great deal in this market."

For his part, Roseen views recent market gyrations much the same. He points out that closed-end bond funds discounts now are running at right around their long-term historical averages. "I like to personally buy when discounts are deeper," Roseen said.

He agrees that closed-end fund discounts might widen later in the year. "The bond fund market still is facing some issues that should raise some red flags," Roseen added.

In the week ended Aug. 23, intraday taxable bond fund prices rose on average between 10% to 11%, the Citigroup report found. "Some investors have even realized investment returns of 20% in less than a week -- this from a sector in which high-single digit annual returns are typically viewed as pretty good," the analysts wrote.

Credit risks, relatively large amounts of new corporate bond issues and increasing dividend pressures makes the rally of closed-end bond funds difficult to judge on a longer-term basis, Sileo added.

Two primary risks should be kept in mind for anyone considering entering the closed-end fund market, he said. Those include weaker NAVs and continuing pressure on dividends.

"With closed-end prices back to trading very close to NVS, there's very little cushion to absorb either of these risk factors should they occur," Sileo added.

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